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Financial Stocks Have Been Rallying Ahead Of Upcoming Q3 Earnings

Earnings season kicks into full gear in the next few weeks, with some of the biggest banks in the financial sector gearing up to report their results. Citigroup Inc (NYSE: C) andJPMorgan Chase & Co. (NYSE: JPM) report before market open on Thursday, October 12; Bank of America Corp (NYSE: BAC) and Wells Fargo & Co (NYSE: WFC) report before market open on Friday, October 13. The following week, Goldman Sachs Group Inc (NYSE: GS) and Morgan Stanley (NYSE: MS) report before market open on Tuesday, October 17.

Wall Street analysts have said they are expecting positive earnings growth from the major banks, with consensus estimates calling for growth that ranges from low to high-single digits. Outside of upcoming earnings, the spotlight has been back on the financial sector following the Federal Open Market Committee’s September meeting and the initial framework for proposed tax reform. Below we’ll look at what’s been going on in the sector.

FIGURE 1: SEPTEMBER RALLY. During a quiet month of trading in August that was impacted by uncertainty regarding the extent of hurricane damage and the potential impact on insurers and other financial companies, the S&P Financial Select Sector Index ($IXM) gave up most of its gains on the year. In September though, the index sharply rallied and is up 11.24% year-to-date as of October 4, compared to a 12.26% increase in the S&P 500 (SPX), which is the purple line in the chart above. Chart source: thinkorswim® by TD Ameritrade. Data source: Standard & Poor’s. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

The Federal Reserve, Interest Rates and Balance Sheet Unwinding

Even though interest rates have remained low, they’ve started to creep up again. Generally, as interest rates go up, some of that gets passed onto consumers and businesses in the form of higher interest on their deposits.

As of this morning, the CME’s FedWatch Tool puts the odds of a .25% hike to the fed funds rate at 76%. In the past, rate hikes have typically happened when the probability has been above 70%. A quarter of a percent difference in interest rates might not have a big impact on your average consumers’ deposits, but when it comes to the banks, additional interest is being earned on hundreds of billions of dollars.

Several analysts have reported that banks have been increasing interest rates for high net worth individuals and larger businesses but that they’ve held out on raising rates for other consumers and smaller businesses.

The Fed is also kicking off its plans to start unwinding its balance sheet in October. While there’s a lot of speculation about how this will ripple through markets, one of the expected impacts is a rise in longer-term interest rates in the United States, according to the Wall Street Journal.

Despite recent rises in Treasury yields and the Fed starting to unwind its balance sheet, the yield curve remains pretty flat. A steeper yield curve, the difference between long-term and short-term interest rates, typically helps boost banks’ net interest income—the difference between revenues generated by a bank’s assets and the expenses associated with paying its liabilities. With a more hawkish tone out of Janet Yellen at the last Fed meeting, and the potential for a more hawkish Fed chair when Yellen’s term expires in February next year, many analysts have indicated they aren’t expecting the curve to stay flat for too much longer.

FIGURE 2: FED DOT PLOT. The Fed’s “dot plot” shows each Federal Open Market Committee (FOMC), the policy-setting arm of the Federal Reserve, meeting participants’ judgment of the appropriate midpoint of the target range for the fed funds rate at the end of the specified calendar year and over the longer run. Right now, Fed governors seem to be in agreement on another hike at December’s meeting. Looking further out, it indicates there’s more uncertainty regarding where rates should be in the next few years. For illustrative purposes only.

Waiting on Reform

More concrete details regarding Republicans’ tax plans came out towards the end of September with a proposal to slash the corporate income tax rate from 35% to 20% as well as a repatriation tax break that would allow companies to bring back overseas profits to the United States at a lower tax rate.

Based on initial market reactions, the plan seems like it would be a positive for the financial sector. On top of banks in the sector potentially benefitting from the lower corporate tax rate, analysts have said that they also expect that banks could benefit from the influx of repatriated cash. Many companies in other sectors have already indicated they would use repatriated cash on mergers and acquisitions, share buybacks, and other activities that banks earn fees on.

Despite optimism surrounding some potential reforms, these things will take a while to play out, there will be a negotiating process between House Democrats and Republicans, and any eventual reform is likely to be different than the initial proposal. The same is true for proposals to overhaul Dodd-Frank and potentially eliminate the Volcker Rule, which restricts banks’ trading and investing activities.

That uncertainty might be causing some investors and traders to sit on the sidelines until they know more. At the same time, many businesses have indicated they’re waiting until the reforms are more concrete and likely to pass before solidifying plans with excess cash from lower corporate taxes. As we’ve seen in the financial sector over the past year, the initial reform headlines have led to big moves, but we’re still waiting to see what actually makes it through the House of Representatives.

Volatility Remains Low, Pressuring Trading Revenue

Despite a few brief bouts of volatility in August and the beginning of September, markets remained strong and for the most part have shrugged off several major hurricanes, concerns regarding North Korea’s missile launches, and more as the VIX dropped back below 10. Low volatility across markets has pressured fixed income, currency, commodity, and equity trading revenue at some of the biggest banks this year. Volatility isn’t likely to remain low forever, it’s just a matter of what might be the catalysts that bring it back and which banks might benefit from the uptick in trading activity.